20 : Theory of Cost
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Session Outline
Production cost
Types of Cost: Accounting/Economic Analysis
Cost –Output Relationship
Short run cost Analysis
Prof. Trupti Mishra, School of Management, IIT Bombay
Cost of Production
Business decisions are generally taken based on the monetary
values of inputs and outputs.
The quantity of inputs multiplied by their respective unit
prices will give the monetary value or the cost of production.
Prof. Trupti Mishra, School of Management, IIT Bombay
Importance of Production cost
In all business decisions, especially those decisions
concerning:
 the location of the weak points in production management;
cost minimisation
finding the optimal level of output;
determination of price and dealers’ margin; and,
estimation of the costs of business operation.
Prof. Trupti Mishra, School of Management, IIT Bombay
Category of cost
 Concepts used for accounting purposes; and,
 Analytical cost concepts used in economic analysis of
business activities.
Prof. Trupti Mishra, School of Management, IIT Bombay
Accounting Cost Concepts
Opportunity Cost and Actual or Explicit Cost
Opportunity cost can be seen as the expected returns from
the second best use of an economic resource which is
foregone due to the scarcity of the resources
Prof. Trupti Mishra, School of Management, IIT Bombay
Accounting Cost Concepts
Opportunity Cost and Actual or Explicit Cost
The actual or explicit costs are those out-of-pocket costs of
labour, materials, machine, plant building and other factors
of production.
Prof. Trupti Mishra, School of Management, IIT Bombay
Accounting Cost Concepts
Business and Full Costs
All the expenses incurred to carry out a business are referred to
as business costs.
Similar to actual or real costs, and include all the payments and
contractual obligations made by the firm, together with the
book cost of depreciation on plant and equipment.
Used in calculating business profits and losses and for filing
returns for income tax and for other legal Purposes.
Prof. Trupti Mishra, School of Management, IIT Bombay
Accounting Cost Concepts
Full costs include business costs, opportunity costs and
normal profit, while normal profit represents a necessary
minimum earning in addition to the opportunity cost, which
a firm must receive to remain in business.
Prof. Trupti Mishra, School of Management, IIT Bombay
Accounting Cost Concepts :
Explicit and Implicit/Imputed Costs
These are costs falling under business costs and are those
entered in the books of accounts. Payments for wages and
salaries, materials, insurance premium, depreciation charges
are examples of explicit costs.
These costs involve cash payments and are recorded in
accounting practices.
Prof. Trupti Mishra, School of Management, IIT Bombay
Accounting Cost Concepts
Implicit/Imputed Costs
•Those costs that do not involve cash outlays or payments and
do not appear in the business accounting system are referred to
as implicit or imputed costs.
•Implicit costs are not taken into account while calculating the
loss or gains of the business
•The explicit and implicit costs together (explicit +implicit costs)
form the economic cost.
Prof. Trupti Mishra, School of Management, IIT Bombay
Accounting Cost Concepts : Out-of-Pocket and Book Costs
Expenditure items that involve cash payments or cash
transfers, both recurring and non-recurring, are referred
to in economics as out-of pocket costs.
All the explicit costs including wages, rent, interest, cost of
materials, maintenance, transport expenditures, and the
like are in this classification.
Prof. Trupti Mishra, School of Management, IIT Bombay
Accounting Cost Concepts :Out-of-Pocket and Book Costs
Some actual business costs which do not involve cash
payments, but a provision is made in the books of account and
they are taken into account while finalizing the profit and loss
accounts.
Such costs are known as book costs.
These are somehow, payments made by a firm to itself.
Prof. Trupti Mishra, School of Management, IIT Bombay
Analytical Cost Concepts Used in Economic Analysis of Business
Activities.
Fixed and Variable Costs
Total, Average, and Marginal Costs
Short-Run and Long-Run Costs
Incremental Costs and Sunk Costs
Historical and Replacement Costs
Private and Social Costs
Prof. Trupti Mishra, School of Management, IIT Bombay
Fixed and Variable Costs
Costs that are fixed in volume for a certain level of output.
They do not vary with output.
They remain constant regardless of the level of output.
Fixed costs include:
(i) Cost of managerial and administrative staff; (ii) Depreciation of
machinery; (iii) Land, maintenance.
Fixed costs are normally short-term concepts because, in the longrun, all costs must vary.
Prof. Trupti Mishra, School of Management, IIT Bombay
Fixed and Variable Costs
Variable Costs are those that vary with variations in output.
It includes: (i) Cost of raw materials; (ii) Running costs of fixed
capital, such as fuel, repairs, routine maintenance expenditure,
direct labour charges associated with output levels; and
(iii) The Costs of all other inputs that may vary with the level of
output.
Prof. Trupti Mishra, School of Management, IIT Bombay
Total, Average, and Marginal Costs
The Total Cost (TC) refers to the total expenditure on the
production of goods and services.
It includes both explicit and implicit costs.
The explicit costs themselves are made up of fixed and variable
costs.
Prof. Trupti Mishra, School of Management, IIT Bombay
Total, Average, and Marginal Costs
The Average cost (AC) is obtained by dividing total cost
(TC) by total output (Q).
AC = TC/Q
Prof. Trupti Mishra, School of Management, IIT Bombay
Total, Average, and Marginal Costs
Marginal Cost (MC) is the addition to total cost on account of
producing one additional unit of a product.
It is the cost of the marginal unit produced.
MC = Change in TC/ Change in Q = ΔTC/ ΔQ
Prof. Trupti Mishra, School of Management, IIT Bombay
Short-Run and Long-Run Costs
Short-Run Costs are costs which change as desired output
changes, size of the firm remaining constant. These costs are
often referred to as variable costs.
Long-Run costs, on the other hand are costs incurred on the
firm’s fixed assets, such as plant, machinery, building, and the
like.
Prof. Trupti Mishra, School of Management, IIT Bombay
Incremental Costs and Sunk Costs
Refers to the total additional cost associated with the decision to expand
output or to add a new variety of product.
The concept of incremental cost is based on the fact that, in the real world,
it is not practicable to employ factors for each unit of output separately
due to lack of perfect divisibility of inputs.
It also arise as a result of change in product line, addition or introduction
of a new product, replacement of worn out plant and machinery,
replacement of old technique of production with a new one, and the like
Prof. Trupti Mishra, School of Management, IIT Bombay
Incremental Costs and Sunk Costs
The Sunk costs are those costs that cannot be altered, increased
or decreased, by varying the rate of output.
once management decides to make incremental investment
expenditure and the funds are allocated and spent, all preceding
costs are considered to be the sunk costs since they accord to the
prior commitment and cannot be reversed or recovered when
there is a change in market conditions or a change in business
decisions.
Prof. Trupti Mishra, School of Management, IIT Bombay
Historical and Replacement Costs
Historical cost refers to the cost an asset acquired in the past,
whereas, replacement cost refers to the outlay made for replacing
an old asset.
These concepts derive from the unstable nature of price behaviour.
When prices become stable over time, other things being equal,
historical and replacement costs will be at par with each other.
Prof. Trupti Mishra, School of Management, IIT Bombay
Private and Social Costs
Private and social costs are those costs which arise as a result of
the functioning of a firm, but neither are normally reflected in
the business decisions nor are explicitly borne by the firm.
Costs in this category are borne by the society.
Prof. Trupti Mishra, School of Management, IIT Bombay
Private and Social Costs
Total cost generated in the course of doing business may be
divided into two categories:
(i) those paid out by the firm; and,
(ii) those not paid or borne by the firm, including the use of
resources that are freely available plus the disutility created
in the process of production.
Costs under the first category are known as private costs. Those
of the second category are known as external or social costs.
Prof. Trupti Mishra, School of Management, IIT Bombay
Private and Social Costs
Examples of such social costs include:
water pollution from oil refineries,
air pollution costs by mills and factories located near a city etc
From a firm’s point of view, such costs are classified as external
costs, and from the society’s point of view, they are classified as
social costs.
Prof. Trupti Mishra, School of Management, IIT Bombay
The theory of costs basically deal with cost-output relations.
The basic economic principle states that total cost increases with
increase in output.
However, focus is not the absolute increase in total cost, but the
direction of change in the average cost (AC) and the marginal
cost (MC).
The direction of changes in AC and MC will depend on the nature
of the cost function.
Prof. Trupti Mishra, School of Management, IIT Bombay
Cost – Output Relationship
A cost function is a symbolic statement of the technological
relationship between the cost and output.
C = TC = f(Q), and ΔQ > 0,
The specific form of the cost function depends on the time
framework for cost analysis: short-or long-run.
Prof. Trupti Mishra, School of Management, IIT Bombay
Short Run Costs
• Total Variable cost (TVC)
– Total amount paid for variable inputs
– Increases as output increases
• Total Fixed Cost (TFC)
– Total amount paid for fixed inputs
– Does not vary with output
• Total Cost (TC) = TVC + TFC
Prof. Trupti Mishra, School of Management, IIT Bombay
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Short-Run Total Cost Schedules
Output (Q)
0
Total Fixed cost
(TFC)
6,000
100
6,000
200
6,000
300
6,000
400
6,000
500
6,000
600
6,000
Total Variable cost
(TVC)
Total Cost
(TC=TFC+TVC)
0
6,000
4,000
6,000
10,000
12,000
9,000
14,000
15,000
20,000
22,000
34,000
28,000
40,000
Prof. Trupti Mishra, School of Management, IIT Bombay
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Total Cost Curves
Prof. Trupti Mishra, School of Management, IIT Bombay
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Average Costs
AVC
TVC
Q
AFC
TFC
Q
ATC
TC
Q
AVC
AFC
Prof. Trupti Mishra, School of Management, IIT Bombay
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Short Run Marginal Cost
• Short run marginal cost (SMC) measures rate of change in total cost (TC) as
output varies
SMC
TC
Q
TVC
Q
Prof. Trupti Mishra, School of Management, IIT Bombay
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Average & Marginal Cost Schedules
Output
(Q)
Average fixed
cost
(AFC=TFC/Q)
Average
variable cost
(AVC=TVC/Q)
Average total
cost
(ATC=TC/Q=
AFC+AVC)
Short-run
marginal cost
(SMC= TC/ Q)
0
--
--
--
--
100
60
40
100
40
200
30
30
60
20
300
20
30
50
30
400
15
35
50
50
500
12
44
56
80
600
10
56.7
66.7
Prof. Trupti Mishra, School of Management, IIT Bombay
120
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Average & Marginal Cost Curves
Prof. Trupti Mishra, School of Management, IIT Bombay
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Short-Run Production & Cost Relations
Panel A
Panel B
Prof. Trupti Mishra, School of Management, IIT Bombay
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Relations Between Short-Run Costs & Production
• When marginal product (average product) is increasing,
marginal cost (average cost) is decreasing
• When marginal product (average product) is decreasing,
marginal cost (average variable cost) is increasing
Prof. Trupti Mishra, School of Management, IIT Bombay
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Relations Between Short-Run Costs & Production
• When marginal product = average product at maximum AP,
marginal cost = average variable cost at minimum AVC
Prof. Trupti Mishra, School of Management, IIT Bombay
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Short run Cost Function
Cost-output relations are normally determined by the cost
function and are exhibited by cost curves.
The shape of cost curves depends on the nature of the cost
function which are derived from actual cost data
Prof. Trupti Mishra, School of Management, IIT Bombay
Linear Cost Function.
TC = C = a + bQ
where a = Total Fix Cost (TFC),bQ = Total Variable Cost
(TVC)
The Average and Marginal cost functions can be obtained
from the Total Cost Function as follows:
Average Cost (AC) = TC = a + bQ = a/Q + b Q / Q
Marginal Cost (MC) = dTC/dQ = b
Prof. Trupti Mishra, School of Management, IIT Bombay
Quadratic Cost Function.
TC = C = a + bQ + Q2
AC = TC = a + bQ + Q 2 = a/Q + bQ/Q + Q
MC = dTC/dQ = b + 2Q
Example, if TC = C = 150 + 10Q + Q2
Then, AC = 150/Q + 10Q + Q 2
= 150/Q + 10 + Q
MC = dTC/dQ = 10 + 2Q
Prof. Trupti Mishra, School of Management, IIT Bombay
Cubic Cost Function
TC = C = a + bQ – cQ2 + dQ3
AC = TC = a + bQ – cQ 2 + dQ 3
= a/Q + b – cQ + dQ2
MC = dTC/dQ = b – 2cQ + 3dQ2
Assume that the cost function is empirically and explicitly
estimated as:
TC = 10 + 6Q – 0.9Q2 + 0.05Q3
And, TVC = 6Q – 0.9Q2 + 0.05Q3
Prof. Trupti Mishra, School of Management, IIT Bombay
AFC = FC/Q = 10/Q
AVC = TVC/Q = 6Q – 0.9Q 2 + 0.05Q 3 /Q
= 6 – 0.9Q+0.05Q2
ATC = TC/Q = 10 + 6Q - 0.9Q 2 + 0.05Q 3/Q
= 10/Q + 6 – 0.9Q + 0.05Q2
MC = dTC/dQ = 6 – 1.8Q + 0.15Q2
Prof. Trupti Mishra, School of Management, IIT Bombay
Session References
Managerial Economics; D N Dwivedi, 7th Edition
Managerial Economics – Christopher R Thomas, S Charles
Maurice and Sumit Sarkar
Micro Economics : ICFAI University Press
Prof. Trupti Mishra, School of Management, IIT Bombay
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